The Tax Cuts and Jobs Act of 2017 has impacted virtually every business taxpayer, including private equity firms and their portfolio companies. After nearly two years, investors continue to grapple with the myriad new tax rules that may weigh on their dealmaking decisions and business models— from the positive effect of lower corporate tax rates to the June 2018 South Dakota v. Wayfair decision by the U.S. Supreme Court regarding sales tax.
As 2020 begins, here are three critical tax issues expected to impact private equity, along with suggestions for how firms and their portfolio companies should approach them to avoid potential pitfalls:
State and local tax. Nexus laws determine the state(s) in which a company has a filing responsibility. Before the Wayfair decision, physical presence in a state determined where a company was required to collect sales tax, known as its sales tax nexus. Now, sales tax nexus can also be created through economic activity.
Private equity firms buying or selling a portfolio company need to be aware that the Wayfair decision could significantly impact the company’s financials. If a company owes tax due to the identification of nexus in states where it has not been collecting sales tax, the tax liability, penalties and interest can be steep.
Stakeholders on both sides of a transaction should consider conducting a nexus study as part of their overall due diligence process. This will allow them to better assess any state tax nexus risks and, if warranted, implement purchase price adjustments, indemnifications or escrow accounts.
International tax and GILTI. The U.S. Treasury and IRS have finalized global intangible low-taxed income, or GILTI, regulations for U.S. taxpayers owning an interest in controlled foreign corporations—multinational companies with more than 50% of the total voting power or stock value owned by U.S. shareholders. New GILTI regulations allow these companies to allocate a portion of specified domestic expenses to their foreign subsidiaries and employ unused foreign tax credits, thereby lowering their overall tax burdens.
The procedures and calculations surrounding GILTI, and many other evolving international tax regulations, are complex and will continue to change. Private equity investors in companies with multinational operations should seek to develop a proactive and holistic tax strategy for their foreign investments, if they have not already done so.
Business interest expense deductions. Modifications to the tax code are imposing limitations on business interest expense deductions. In the past, most companies could fully deduct business interest expense. Pending rule changes, which are viewed by some as creating greater parity for debt versus equity financing, are prompting private equity investors to reassess their deal structures moving forward.
Like the new state, local and international tax rules, it is still unclear how modifications to business income expense deduction regulations will impact deals and deal financing. Our advice to private equity investors is to get out in front of these changes sooner rather than later, now that 2020 has begun.
Jeremy Swan is the national director of CohnReznick’s Financial Sponsors & Financial Services Industry practice and leads the efforts of the firm’s M&A Consulting Services practice.
Jonathan Collett is a partner of CohnReznick and a member of the firm’s Financial Services Industry practice.